Archive for December, 2012

I repeat, don’t kill the goose that lays the golden eggs

In an earlier blog on this site (5 August 2011), I had cautioned against what might be termed a short-term revenue based approach to infrastructure investments, arguing that this would seriously harm investor sentiment. A year and more down the road, I note with considerable anguish that my earlier apprehensions are coming true with a vengeance. While my earlier blog focused only on the upstream petroleum sector, we now see that the virus of short-term policy making expediency has spread like a cancer to various parts of the Indian ‘body economic’ which, if not halted at the earliest, can seriously affect investor sentiment. While my earlier focus was on the petroleum (specifically the upstream exploration and production) sector, I would now touch on events in other sectors which point to a spreading malaise. There are, as I see it, four primary factors for this state of affairs:

a)       Bumbling regulation:  My last blog (7 December 2012) highlighted major shortcomings in the regulatory framework in the upstream petroleum sector. In that blog, I had refrained from questioning the competence of the Directorate General of Hydrocarbons (DGH) to regulate and supervise the petroleum operations of companies with which the Government of India had signed production sharing contracts (PSC). Now, a friend who read that blog has brought to my notice that in the Ravva field (Krishna-Godavari basin) PSC, the DGH insisted that the contractor should drill more wells even though the contractor had achieved the agreed production levels by drilling a lesser number of wells (and no production gain would have resulted by drilling more wells). This must be the first case of its kind where a regulator sought to enhance the capital cost of a project, apparently unmindful of its adverse implications for the profit petroleum share that would accrue to the government. [My blogs of 30 November and 7 December 2012 have explained in detail the economics of upstream petroleum operations under a PSC]. While I am not aware of the final outcome in this case, it reflects a very poor understanding of both the technical and financial aspects of petroleum operations. Add to this the other episodes listed in my blog of 7 December 2012 and you would understand why there is increasingly lukewarm investor response to the offer of exploration blocks in successive bidding rounds under the New Exploration Licensing Policy.

b)      Contractual sanctity and pussyfooted policy: Considering that all major decisions in government (especially the Government of India) are taken after voluminous file notings and consultations with all concerned Ministries, the flip-flops in government policy in the past few years have been truly astounding. I will again take up examples from the petroleum sector (with which I am familiar). As far back as 1986, the Petroleum Ministry took a considered decision, with approval at the highest levels, to exempt investors in oil and gas exploration ventures from the payment of royalty. This was to encourage private foreign investment in exploration at a time when international prices were in the region of US$ 12 a barrel and any upfront deduction from revenue (as in the case of royalty) would have kept away investors. This policy was continued in the bidding rounds held after 1991; it was only with the advent of the New Exploration Licensing Policy in 1998 that royalty payment was incorporated in the fiscal package. This did not, however, deter the Government of India from departing from the contract provisions in the PSC with Cairn India for the Barmer block in Rajasthan and demanding, as a condition for approving the sale of interest in Cairn India to Vedanta, the payment of royalty. In my blog of 5 August 2011, I had pointed out how this move represented a breach of contract by the Government of India and why the payment of royalty would, in the final analysis, make little difference to the share of oilfield revenues accruing to the government. That Vedanta agreed to the condition in their anxiety to obtain government permission is beside the point; the government chose to alter the PSC when there was no logic in doing so and no interests of government or the country had been compromised. A second and more recent case is the gas price finalisation for gas produced from the D-6 gas field in the offshore Krishna-Godavari basin operated by Reliance Industries and its partners. The bid conditions when the block was offered clearly stipulated that the contractor was free to market the gas. The 2006 report of a Committee of officials of the Petroleum Ministry which prepared the guidelines for government approval for gas pricing under PSCs categorically stated that where gas prices had been arrived at on the basis of open competitive bidding (OCB), there was no need for government to interfere with the same. And yet, when the National Thermal Power Corporation was able to secure a deal for gas supply from Reliance at US$ 2.34 per million BTU, the Petroleum Ministry did not accept this bid. There was talk (fuelled by uninformed press reports) that the government stood to lose revenues from the field on account of the low gas prices. This was in spite of the fact that it was a government corporation that was benefiting from the lower gas price and the end-consumer would have been the ultimate beneficiary. And yet, when the same Reliance asked for gas prices higher than US$ 4.20 per million BTU, the Government of India was reluctant to look at a reasonable price for gas in the region. A higher gas price would have also given government a greater share of profit petroleum consequent on increased revenues from the gas field. In this Dr. Jekyll and Hyde situation, it will be very difficult for any private company to do business with the government, given that no one can predict flip-flops by future governments.

c)       Mistrust and bureaucratic inertia:  At the best of times, the private sector has found the Indian bureaucracy to be slow and obstructive, with petty harassment at various levels. Now, the prevailing atmosphere of suspicion of any major government decision has brought the bureaucracy at the higher levels to an almost complete stop. This paranoia seems to have affected the ministers as well: every decision goes to the Cabinet and/or to an Empowered Group of Ministers. Decision making has obviously been a casualty in such an environment. Matters are not helped by ill-informed and widespread media (especially electronic media) reporting that targets specific Ministers and bureaucrats. The slow, tortuous legal process in India is a matter of dread for any honest government functionary: once he is enmeshed in some enquiry, it can take anywhere from ten to twenty years to clear his name, with both his reputation and his career in tatters. At the same time, the failure to quickly bring to a closure corruption cases already under way only deepens the public suspicion that the powerful are above the law.

d)      Political posturing and doublespeak: Partisan politics has in the last couple of years played havoc with economic decision making. Take the case of foreign direct investment (FDI) in retail. The main opposition party had espoused this cause when it was in power – now, it suddenly discovers many evils in the policy. Other parties are no better – their response is dictated more by political exigencies and less by the merits of the policy. Opening up the insurance and pension sectors has run into the same roadblocks. Even the debate on the FDI retail issue has had its share of factual inaccuracies. The Bharatiya Janata Party (BJP) claimed that foreign fast food chains were importing potatoes for making French fries. The companies promptly issued rejoinders to the effect that the potatoes were wholly sourced from within India – in what is probably the greatest irony, the potatoes were sourced from farmers in Gujarat state, ruled for fifteen years now by the BJP. While the position of the Left is understandable, given their antipathy to foreign investment in any form (even when such investment makes sound economic sense), the position of other parties, especially those hoping to come to power at Delhi or in different states, seems to be dictated by political expediency. It is almost as if they are afraid to give any credit for successful policies to the political party currently in power and will back these policies once the levers of power are in their hands. Since this is likely to be a zero-sum game, given that no party looks like cobbling together a respectable majority to push through economic reforms, the result could well be legislative paralysis over an extended period of time.

2.                Opinion and decision makers in government, political parties, the media and academia need to clarify their positions on economic reforms, foreign investment and the overall role of the private sector in the growth process. Open thinking on these issues is all the more imperative since India is competing with a host of other nations to secure investment opportunities. Newer and newer countries are emerging as attractive investment destinations, ranging from the old Indo-China region to Africa and Latin America. India (and Indians) must shed their schizophrenic attitude to private investment. If India as a country wants to export its manpower and capital to other countries to earn foreign exchange and grab a greater share of the economic pie, it must equally welcome such investment. In fact, a situation is developing where, confronting the difficulty of doing business in India, even private Indian companies are looking for investment opportunities in other countries, thereby reducing the scope for job and income-creating opportunities within India. Let us pray that we do not reach a situation where private companies, Indian and foreign, take too literally the words of Mohammad Rafi’s immortal lines from the song from the film Pyaasa in beating a retreat from Indian shores:

Mere saamne se hata lo ye duniya

Tumhari hai tum hi sambhalo yeh duniya

Yeh duniya agar mil bhi jaaye to kya hai  

The Indian upstream petroleum sector — a case for effective regulation

My last blog (30 November) detailed the fiscal regime in the upstream petroleum (exploration and production) sector. The intention was to show why the Government of India went in for a progressive resource rent taxation regime related to the profitability of a specific oil/gas field in the New Exploration Licensing Policy (NELP) bidding rounds. It would, however, be necessary to also point out the dangers inherent in any profit-based taxation scheme and the need for effective regulatory mechanisms to monitor pricing, production and costs in an oil/gas production venture to ensure that governments are not deprived of their rightful shares of revenue.
Let us start with the concept of ‘gold plating’ of costs. As the name suggests, this is nothing more than companies attempting to inflate costs of projects to show reduced profits, thereby reducing the tax they pay the government. In production sharing contract (PSC) systems, which (in the Indian context) should be more rightly termed ‘profit-sharing contract’ systems, since it is the profits from the project that are split between the government and the contractor, the contractor has (if not properly regulated) the incentive to show inflated estimates of the costs incurred by it on exploration, development and production operations. Since, under the NELP, cost recovery is the first charge (after royalty payment) on field revenues, higher costs translate into a lower volume of revenues available for profit sharing; as the previous blog shows, this also leads to the project showing a lower level of profitability (in terms of the pre-tax Investment Multiple {IM}) and placing the government-contractor sharing in the lower tranches of the IM. Government is then placed in a situation where it gets a lesser percentage of an already depleted profit petroleum.
Companies could conceivably attempt to restrict the share of profit petroleum flowing to the government by bidding absurdly high shares of profit petroleum for the government at relatively low IM tranches. Since lower tranches are reached relatively early in the life of field production, this distorts the net present value of the project at the time of bid evaluation in favour of such a bidder and ensures that it is successful in its bid. Subsequently, during the operation of the PSC, as long as the project does not enter the tranche where government draws a high share of the profits (or where low absolute profit petroleum gives only a meagre share of the overall field revenue to government), the contractor stands to garner a lion’s share of the field revenues. This situation can be brought about by the contractor in one or more of three ways:
(i) The contractor can enter into arrangements with sub-contractors to charge exorbitant prices for services rendered or goods provided in exploration, development and/or production operations. Of course, the contractor itself benefits financially from such an arrangement only if the sub-contractor is an affiliate or works out some system with the contractor to share the economic rent derived from overcharging for services. The contractor may also enhance production (or operational) costs by charging high overheads;
(ii) Cutting back on annual production enables the contractor to reduce the annual flow of revenue and thereby curtail profitability for a given level of cost recovery. This will push the profit-sharing numbers into a lower tranche, with a lesser percentage accruing to the government apart from also reducing the absolute amount of profit petroleum available in a particular year for division between the government and the contractor. There is also then a possibility that lower levels of annual production can be sustained over a greater number of years at lower levels of profitability, cutting into the government take;
(iii) Pricing of the final product – oil and/or gas – can influence the overall profitability of the venture. Sale of the oil/gas to a subsidiary or affiliate of the contractor or to a company with which the contractor has some undisclosed arrangement at prices lower than what would have obtained in a free market transaction will diminish the gross revenue as well as the profit petroleum.
It is in this context that strong and effective regulatory systems need to be in place to ensure that the contractor is carrying out petroleum operations in accordance with best industry practices. The experience of the Indian upstream petroleum sector in this regard has been discouraging, to say the least. Either the upstream regulator, the Directorate General of Hydrocarbons (DGH), has not performed the role assigned to it or the government has not empowered it in a manner enabling it to carry out its responsibilities effectively. So what are the attributes that make for a good regulator and how has the DGH fared in that regard? On two important criteria for a strong, effective regulator, the DGH comes out with a less than satisfactory report card:
(i) Autonomy: The selection of the person to head the regulatory body must be through an impartial, rigorous process. Right from 1993, the Government of India has kept the powers to appoint the DGH. Not only that, the DGH and the staff under him are drawn from the two national oil companies, Oil and Natural Gas Corporation and Oil India Ltd. In such a setting, with their future careers dependent on their respective government-owned corporations, there is every likelihood that any decision of the DGH would be seen as being weighted in favour of the government and the national oil companies, even if such is actually not the case. The temporary nature of their sojourn in the DGH also tends to make the DGH operatives naturally conservative and risk-averse – add to that the general tendency in the Indian system to view every decision with suspicion and you have a perfect recipe for a “pass the buck” syndrome to develop in the DGH. Not surprisingly, decision-making on PSC issues is almost totally Ministry-based, leading to interminable delays. As a party to the PSC, the Petroleum Ministry should not be the adjudicator in PSC issues where government and company interests and interpretations could (and often do) diverge. Recent history has thrown up instances where the Government of India has intervened in matters which ought to have been determined by the provisions of the PSC. The approval of the interest transfer in Cairn India to Vedanta only after the latter agreed to payment of royalty in the Rajasthan discovery (in contravention of the agreed PSC provisions) and the continuing imbroglio over the price payable for gas produced from the D-6 field in the Krishna-Godavari basin are but two instances where a straightforward interpretation of the PSC provisions has not been adhered to by the Government of India. Recently, we read of Cabinet approval being required for Cairn India undertaking exploration activity in its discovered field in the Barmer basin with the aim of augmenting oil reserves, when the matter related to essentially a technical decision that should have fallen within the jurisdiction of the DGH.
(ii) Competence: It is not my intention (nor within my abilities) to comment on the technical capabilities of the DGH personnel. Suffice it to say that deputing personnel for a certain tenure to the DGH is certainly not the best way to develop PSC and oil/gas field management competencies in the DGH. Three recent examples show how the DGH has not played the role that would have been expected of a strong regulator. Curiously, all three cases relate to the D-6 block where the Reliance-BP-Niko consortium is producing gas from an early NELP contract award. The first concerns the excessive expenditure allegedly incurred by the contractor in developing and producing gas from the field. An effective regulator would have analysed the expenditures in relation to the oil/gas production and taken a view on whether to allow the costs for cost recovery purposes. If the regulator was confident of its assessment, it would have been ready to face the challenge of determining the appropriateness of the costs incurred by the contractor through an arbitration process. In the D-6 case, at least from the newspaper articles, one only understands that approval to the development plan was withheld and subsequently granted. When challenged by the contractor to go in for arbitration, the government appears to have backtracked on its earlier stand. Such a knee-jerk approach shows neither the Petroleum Ministry nor the DGH in a favourable light. A second issue relates to the falling gas production from the field, far below the estimates originally projected by the contractor. While there have been all sorts of wild speculation on the reasons for the same, there has been no indication (or any clarification from the side of the DGH) as to why the production has fallen off so sharply. If the DGH was of the view that the contractor had wilfully reduced production, it should have taken necessary steps to compel the contractor to increase production by invoking the relevant provisions of the PSC. By failing to do so, the DGH created doubt in the public mind about the reasons for the fall in production, putting the government’s credibility at stake. Thirdly, there has been unseemly controversy over the pricing of the gas sold from the D-6 field. The PSC provides for the basis for valuation of the gas sold: it is not clear why there has been so much debate on what is essentially a commercial decision and why no effort has been made by the DGH (or the government, for that matter) to clarify the policy in this regard.
It is pointless blaming the DGH for the current state of affairs. The DGH is a creation of the government and it was (and is) the duty of the Government of India to create a strong and effective DGH which can safeguard the interests of the country while also providing a conducive environment for efficient oil and gas field operations. Unless the Government of India takes steps to strengthen the DGH and provide it with autonomy as well as managerial and technical competence, there is every likelihood that the interests of government (and of the country) will be compromised. Not only that, the trend of reduced investor interest in exploration ventures in India will be intensified, with long-term implications for the country’s energy security.